Analysis: The bank for central banks says current monetary policies are outdated

The Bank for International Settlements’ 84th annual report should give Congress and Federal Reserve Chairwoman Janet Yellen a good prodding. The Switzerland-based bank for the world’s central banks suggests that “monetary policy is testing its outer limits,” and that advanced economies, including the U.S., need “balance sheet repair and structural reform.”

Investors should also take note, as the run-up in U.S. stocks has been driven by central bank accommodation using low interest rates. Although near-zero rates are no longer effective in rallying the economy, they have sent investors into equities. “Obviously,” the report concludes, “market participants are pricing in hardly any risks … a powerful and pervasive search for yield has gathered, and credit spreads have narrowed.”

All in all, the report is not good news, especially in light of the latest Federal Open Market Committee meeting, during which policy makers reduced the Fed’s forecast for GDP growth. And that was before last week’s dismal gross domestic product report, which showed a contraction of 2.9%, steeper than an earlier reading of minus 1%.

The two major challenges the report identifies are to improve the economy structurally by raising productivity, and also to put in policy frameworks to more systematically address the financial cycle. Currently, monetary easing happens too quickly during busts, and governments need to find ways to make the policy counteract the financial cycle so it does not exacerbate existing problems or add new ones (such as expansionary monetary policy in recessions, encouraging higher debt levels).

Perhaps due to central bank expansion, the real global economic recovery has been weak, with growth driven by emerging-market economies. While growth is up, it is not on pace to fully make up lost ground. Much of the expansion has been financed by debt, as debt-to-GDP ratios in advanced economies have grown higher. Both public and private debt have grown.

The BIS concludes that the most work is needed in fiscal policy, not only in bringing deficits down, but also in adjusting measurement techniques to better forecast the fiscal picture. This conclusion is shared by the non-partisan Congressional Budget Office, which has repeatedly warned of deficits that are forecast to diminish in the short term but rise over the next decade.

In April, the CBO wrote: “Between 2015 and 2024, annual budget shortfalls are projected to rise substantially — from a low of $469 billion in 2015 to about $1 trillion from 2022 through 2024 — mainly because of the aging population, rising health-care costs, an expansion of federal subsidies for health insurance, and growing interest payments on federal debt.” America needs to help the economy by getting its fiscal house in order, rather than keeping interest rates at rock-bottom levels.

The report suggests that governments should not only try to reduce budget deficits but also attempt to encourage private-sector finance of infrastructure projects. That can be done by reducing regulations that prevent investment in infrastructure, such as President Obama’s lack of approval of the Keystone XL pipeline. Private-sector investment in federally funded projects is limited, even though roads and bridges would benefit from private dollars.

A stronger real economic recovery would also reduce dangerous overreliance on monetary policy. One of the consequences of this accommodative monetary policy has been an exuberant financial market and a weak real recovery, as monetary policy has failed to encourage investment. Central banks should wind down expansionary monetary policy without delay.

In her press conference on June 18, Chairwoman Yellen did not acknowledge that loose monetary policy will eventually lead to inflation. In response to a question from the Economist’s Greg Ip on increasing inflation, she said: “Let me start by saying that inflation continues to run well below our objective, and we’re still some ways away from maximum employment. And for the moment, I don’t see any trade-off whatsoever in achieving our two objectives. They both call for the same policy — namely, a highly accommodative monetary policy.”

Although elsewhere in the press conference Yellen emphasized the uncertainty that lies ahead, she did not seem to see that the Fed’s policies are increasingly unproductive.

The Fed reduced its 2014 growth forecast by seven tenths of a percentage point — from a range of 2.8 to 3.0% to 2.1 to 2.3%. With the new first-quarter GDP report, the Fed will have to lower its growth forecast even further.

What was surprising is that the Fed left its unemployment rate forecast practically unchanged, around 6.2% for 2014. With downgraded economic growth, the only way that unemployment can stay the same is for more people to leave the labor force. The labor force participation rate, now at 62.8%, levels seen in 1978, may well decline further.

Congress needs to take the burden off Chairwoman Yellen and move above partisan politics to enact some sensible policies. Members are in broad agreement that corporate tax rates need to be reduced from 35% to the OECD average of 24%; that more visas are needed for highly skilled immigrants, especially those who want to create jobs; and that regulations need to be streamlined. Bipartisan legislation along those lines has been crafted, but has not been brought to a vote. That needs to change.

With a decline in after-tax corporate profits with inventory valuation and capital consumption adjustments of 13%, the lowest since the fourth quarter of 2008, the stock market might indeed be suffering from a little exuberance. Right now, there is nowhere else for investors to go. But the BIS report reminds us that a little care might be in order.

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